As the burst of shocking revelations about Peregrine Financial Group’s misappropriation of client money slow to a steady drip of press releases from the US legal and regulatory bodies, the key question now is how the second of two major fraud cases in less than nine months may affect the structure of the futures industry.
With the PFG case coming so close on the heels of the MF Global debacle last year, the industry needs to act fast to restore customer confidence in segregated funds and restore the sanctity of customer protection to the industry.
As CFTC Commissioner Gary Gensler said last week “the system failed to protect the customers of Peregrine.”
New rules for FCMs
Unsurprisingly, structural changes are being called for from many corners of the industry. The response from the CFTC has been to fast-track the National Futures Association’s recommendations regarding the oversight of FCM’s segregated accounts, made in May 2012.
These new rules will require FCMs to file daily segregation and secured reports, as well as file bimonthly segregation investment detail reports, reporting how customer segregated and secured funds are being invested and where those funds are held.
They will require senior management of an FCM to approve any withdrawals of more than 25% of the excess segregated funds that are not withdrawn to return to the customer.
FCMs will also need to have sufficient funds in their secured account to meet their total obligations to customers trading on foreign markets computed under the net liquidating equity method.
But none of these really solve the problem that occurred at PFG.
Is segregation the solution?
Russell Wassendorf Sr’s fraud is reported to have involved doctored accounts, giving the impression that PFG had enough funds in secured accounts to meet its obligations. And, with Wassendorf being the CEO of the firm, he would still be eligible to approve the withdrawal of customer money.
Something more is obviously needed to restore confidence to the market and the creation of individually segregated customer accounts is a key part of many of the calls for change.
In Europe, Emir will require CCPs or clearing members to provide individual segregation to customers. Meanwhile in February 2012, the CFTC published a final rule, termed the ‘legal segregation and operational commingling’ model (LSOC), which it claimed would protect customer money on an individual basis all the way to the clearing house.
Although these rules should help, they are not without their problems.
Nothing comes for free
One of the problems with Emir is that it does not definitively state who should provide customers with this individual segregation.
“The contentious question here is: whose responsibility is it? Is it up to every single FCM to offer a segregated model or is it better to, like Eurex is doing, offer it at the exchange source?” explained one industry veteran.
Individually segregated accounts reduce risk and increase transparency for customers because their assets are ring fenced in their name and they have a direct claim to these assets. However, this level of security comes at a cost.
Fully segregated accounts such as these are far more operationally onerous and the process would require every piece of collateral that comes from customers being tagged by the clearing member and registered in an account against that customer.
And how much will this cost end users? It is certain that the price of individual segregation will be greater. What seems most probable at the moment is that there will be different levels of segregation available to customers, with each level having a different price corresponding to the level of segregation required and the transparency and flexibility of that segregation model.
LSOC model limited
When the LSOC model was finalised by the CFTC, Commissioner Scott O’Malia highlighted some of the limitations of the model. Speaking well in advance of the PFG collapse, O’Malia said that the rule benefits cleared swaps rather than futures customers, who suffered most from MF Global’s actions.
He said that LSOC “does not protect against operational risk – namely, the risk that an intermediary improperly segregates cleared swaps customer collateral. Moreover, it does not protect against investment risk – namely, the risk that an intermediary experiences losses on its investment of cleared swaps customer collateral, which it cannot cover using its capital.”
However, O’Malia concluded that the LSOC model needed additional oversight or action from the CFTC rather than it was defunct. One thing that the cases of PFG and MF Global have made clear is that any monitoring of segregated funds needs to take place in as close to real-time as possible.
Industry demands action
There have also been other proposals put forward by the industry to help prevent further frauds. After MF Global, former CFTC chairman and FOW columnist Phillip McBride Johnson championed the creation of a single-purpose central repository to hold customer funds.
Meanwhile Nicolas Breateau, head of the Newedge Group, has come out in favour of a new independent authority that would require brokers to submit information about how much customer money they hold through daily submissions and how much customer money they have deposited in their accounts to ensure that the totals of each made mathematical sense.
Both of these models seem attractive with hindsight, although it must be noted that the creation of any new system-wide entity will incur costs that are likely to be passed down to end-users.
The PFG case has exacerbated problems and concerns that were already evident after MF Global and the industry needs to act fast to restore customer confidence. Whatever response comes from the regulators, it is clear that transparency of segregated funds will be a key USP for FCMs going forward.
Structural changes to the futures industry will be inevitable, as is the fact that the restoration of this confidence will come at a price to end-users. What remains to be seen is how high this price will be.